Money Market Funds are NOT 100% Safe

by Jeff Reeves | August 27, 2012 6:30 am

Hopefully you’ve been following the debate over money market fund reform. If not, you need to be.

Money market fund protections are nuanced and a bit arcane for some investors, but they really matter. Because at stake is how to protect the roughly $2.4 trillion in investments that many investors consider as good as cash under the mattress.

I’ll give you a personal example: When I “go to cash” in my brokerage account, I’m not actually in cash until I move my money out and back into my retail bank. Left to its own devices, my account automatically allocates the money into the BIF Tax-Exempt Fund, a money market fund that makes very low-risk investments in very short-term securities. One share in the fund is intended to have a net asset value of $1, and the fund delivers a minuscule distribution to you based on interest earned.

Sounds as good as cash, right? Better even due to the tiny interest payments. But it’s not that simple.

You see, in the depths of the financial crisis, one of the largest money funds called Reserve Primary Fund suffered losses on debt it held in Lehman Brothers. Yeah, that Lehman. As a result, it could not maintain its $1 per share price.

In short, investors who thought they were safely in cash faced losses.

This phenomenon — known as “breaking the buck” — is a serious deal. After all, the ability to “go to cash” in a crisis is one of the few things retail investors can do to protect themselves. If even that money isn’t safe until it’s 100% out of your brokerage account, then risk-averse investors concerned with capital preservation have legitimate fears that another downturn could erode even their safest investments. They’ll be left no option but to literally stuff money under their mattresses instead.

So, Securities & Exchange Commission Chairman Mary L. Schapiro has rightly pushed the issue of money market reform as a backstop for investors. But unsurprisingly, the big firms have fought tooth and nail against restrictions[1]. After all, Fidelity Investments, Charles Schwab & Co. (NYSE:SCHW[2]) and JPMorgan Chase (NYSE:JPM[3]) make a nice profit from the operations of their money market funds. Considering there’s roughly $2.4 trillion in these kind of investment vehicles, a mere 0.05% in fees and expenses is $1.2 billion in revenue.

Sadly, however, three commissioners at the SEC — a majority — will not support a staff proposal to reform the structure of money market funds. This from a statement Schapiro made last week:

As we consider money market funds’ susceptibility to runs, we must remember the lessons of the financial crisis and the history of money market funds. And, we must be cognizant that the tools that were used to stop the run on money market funds in 2008 no longer exist. That is, there is no “back-up plan” in place if we experience another run on money market funds because money market funds effectively are operating without a net.

In short: When you “go to cash” now, there’s no guarantee that your cash is safe until it’s out of your brokerage account and its money market funds. If a crisis hits, you could get less than 100 cents on the dollar.

This is appalling considering the doubt, fear and mistrust on Wall Street these days. Yes, the chance of another run on money market funds is highly unlikely — but as Schapiro writes: “One of the most critical lessons from the financial crisis is that, when regulators identify a potential systemic risk – or an industry or institution that potentially could require a taxpayer bailout – we must speak up.”

The fact that such an event would be rare does not excuse officials who don’t put needed safeguards in place to protect the investing public.

The fight isn’t over, of course. The SEC and Schapiro may debate a new set of watered-down rules — and while blunted, they could wind up being much better than nothing.

And then there are much more creative options, such as the one floated by Wall Street Journal columnist David Weidner:

“Maybe she should consider something more radical such as an industry-funded reserve that would pay out in a crisis,” Weidner writes. “It would turn the implicit bailout guarantee into a explicit one. Being honest about what’s at stake is a good first step.”

In the meantime, investors need to know what the dangers are here. One of the hardest lessons to learn is that “low risk doesn’t mean no risk.” The money market debate is proof of that.

Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.”[4] Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own any of the stocks named here.

Endnotes:

big firms have fought tooth and nail against restrictions: http://www.bostonglobe.com/business/2012/08/23/fidelity-hails-sec-backtrack-money-market-funds/Av5LHT6zyf0uZ21OvaDJVM/story.html